Alfa Romeo incurs direct cash costs of $30,000 in manufacturing a red convertible automobile during 2016. Assume that it incurs all of these costs in cash. Alfa Romeo sells this automobile to you on January 1, 2017, for $45,000. You pay $5,000 immediately and agree to make annual payments of $14,414 on December 31, 2017, 2018, and 2019. Based on the interest rate appropriate for this note of 4% on January 1, 2019, the present value of the note is $40,000. The interest rate appropriate for this note is 5% on December 31, 2017, resulting in a present value of the remaining cash flows of $26,802. The interest rate appropriate for this note is 8% on December 31, 2018, resulting in a present value of the remaining cash flows of $13,346.

REQUIRED

Ignore income taxes.

a. Assume that Alfa Romeo accounts for this note throughout the three years using its initial present value and the historical interest rate (Approach 1). Indicate the effects of the following events on the balance sheet and income statement. For example, the response to (1) would be: Cash decreases $30,000, and inventory increases $30,000, resulting in no change in total assets.

(1) Manufacture of the automobile during 2016

(2) Sale of the automobile on January 1, 2017

(3) Cash received and interest revenue recognized on December 31, 2017

(4) Cash received and interest revenue recognized on December 31, 2018

(5) Cash received and interest revenue recognized on December 31, 2019

b. Assume that Alfa Romeo values this note receivable at fair value each year with fair value changes recognized in net income (Approach 2). Changes in market interest rates affect the valuation of the note on the balance sheet immediately and the computation of interest revenue for the next year. Indicate the effects of the following events on the balance sheet and income statement.

(1) Manufacture of the automobile during 2016

(2) Sale of the automobile on January 1, 2017

(3) Cash received and interest revenue recognized on December 31, 2017

(4) Note receivable revalued and an unrealized holding gain or loss recognized on December 31, 2017

(5) Cash received and interest revenue recognized on December 31, 2018

(6) Note receivable revalued and an unrealized holding gain or loss recognized on December 31, 2018

(7) Cash received and interest revenue recognized on December 31, 2019

c. Why is retained earnings on December 31, 2019, equal to $18,242 in both cases, despite having shown a different pattern of income over time?

d. Discuss the trade-off in financial reporting when moving from Approach 1 in Part a to Approach 2 in Part b.